Funds take bull market by the horns

Fourth-quarter powers 2004 gains across sectors, styles

SAN FRANCISCO (CBS.MW) -- Mutual fund shareholders enjoyed double-digit U.S. stock gains in 2004 -- the first back-to-back yearly profit since 1999 -- but a "threepeat" performance in 2005 may be too long a reach for some of the bull market's leaders.

Diversified U.S. stock funds gained 12 percent on average, according to research firm Lipper. A powerful 10.7 percent fourth-quarter stock-fund rally began in mid-October and brought a relaxed ending to a year of tense uncertainty. Investors came sufficiently to terms with interest-rate hikes and higher oil prices to push all but one Lipper stock-fund category into the black.

International-stock funds fared notably better than U.S. funds, rising 20 percent on average as a weakening dollar offered investors a world of exchange-rate opportunities. Sector-fund standouts included real estate and natural resources, rising 32 percent and 30.2 percent, respectively.

U.S. fund managers held three almost-foolproof keys to superior 2004 results: natural resources, utilities and telecommunications stocks. Real-estate-related stocks added an extra sweetener. Yet the promise of a third leg for this bull market raises questions about which sectors might lead next year and which could falter.

Investment research firm Standard & Poor's forecasts a gain of 8.3 percent for the S&P 500 Index in 2005, corresponding to 10 percent growth in corporate earnings. Companies are flush with large amounts of available cash that can be used for equipment, acquisitions, dividend increases and share buybacks.

Small-company stock funds, particularly value-focused portfolios with large exposure to soaring energy and utilities shares, held the spotlight for a sixth consecutive year. Small-cap value funds rose 21 percent, topping all diversified U.S. fund categories and surprising many who anticipated that small caps would hand the baton to large-cap rivals.

"It turned out to be an important year for stock pickers," said Kimberly Scott, manager of the Waddell & Reed Advisors New Concepts Fund
UNECX, -0.51%
which gained 19.3 percent in 2004. "It was a more difficult market. Managers who selected good, solid names and stuck with them probably performed better."

Rate of return

The second year of the bull market attracted early buyers, but initial euphoria gave way to widespread political and economic concerns that didn't abate until after November's presidential election.

Still, the pace of investment this year was the strongest since 2000, a notable achievement given the negative market sentiment and the fund scandal's landmark regulatory settlements.

Through November, U.S. and international stock funds added $167 billion in new cash, compared with $138 billion a year ago, according to the Investment Company Institute, a fund-industry trade group. Stock funds may have captured an additional $10 billion in December, according to research firm TrimTabs.com.

International appeal

Small-cap and midcap stocks led markets outside of the U.S. as well, and diversified international funds that own them joined the forward march, rising 24.4 percent on average.

Emerging markets are growing up. The best-performing international portfolio was the U.S. Global Investors Eastern Europe Fund
EUROX, -0.52%
which caught the wave of economic growth in that rapidly developing region and gained 52.4 percent. Rival Eastern European Equity Fund
VEEEX, +1.17%
was close behind with a 48.9 percent return.

The year's top sector funds also invested in an emerging region. Latin American funds turned in a 38.4 percent average gain. Leading the group: Merrill Lynch Latin America fund's Class-A shares
MDLTX, -0.05%
up 43.2 percent.

China region funds went from first to worst among international funds. The sector's 61 percent average return in 2003 outdistanced the pack, but it languished this year with a gain of 9.3 percent.

Reform and perform

Investors savored another rewarding year from funds, but many fund companies felt a punishing sting from federal and state securities regulators. The fund-industry scandal ensnared more firms, resulting in costly settlements and major reforms. Even those funds untouched by allegations of improper trading and murky business dealings are adjusting to a revamped playing field.

"We have started down a difficult road to reform," said John Bogle, the founder of the Vanguard Group and an outspoken industry critic. "Those that were caught in the market-timing scandals were punished, not heavily, but punished nonetheless. Those that had done their best to honor trust were rewarded with substantial cash."

Money poured into firms that steered clear of scandal, notably American Funds, Vanguard, Fidelity Investments and T. Rowe Price Group
TROW, -2.56%
and to boutique firms such as Dodge & Cox, Calamos Asset Management and First Eagle Funds, FRC said.

By December, the high-profile prosecutions by both New York Attorney General Eliot Spitzer and the Securities and Exchange Commission had ebbed noticeably, but the sweeping reforms they spawned already are having a significant impact.

The most powerful SEC rulemaking included requiring an independent fund chairman who is not an employee of the fund's parent, and outlawing the use of brokerage commissions as compensation for selling funds.

Other important reforms still await adoption. Regulators next year are expected to address market-timing, late-trading and 12b-1 fees paid to brokers. The aim is to stem abuses and give fund investors additional tools to make informed decisions before they buy.

"This is no time for complacency," said Paul Stevens, president of the Investment Company Institute, the fund industry's trade group. "The degree of scrutiny will continue. Practices well-established have been called into question."

Scenic overlook

This year's robust small-cap rally -- building on last year's 45 percent average advance -- was enough to give even some small-cap fund managers pause.

"We've been a little surprised at how strong the market's been," said Lee Grout, co-manager of the Berwyn Fund
BERWX, +0.46%
which rose 23 percent. "The stocks have done so well, they may be fairly priced."

Small-company stock valuations were troubling a year ago as well, said Andrew Clark, a Lipper senior research analyst. With moderate economic growth and gradual interest-rate hikes in the offing, he said, small caps -- as well as midcaps -- have room to run.

"Is 2005 going to finally be the year where large beats small?" said Andrew Clark, a Lipper senior research analyst. "I don't think that's going to happen."

"It'll be more selective in small caps, but that's true of the whole market next year," added David Bagby, co-manager of the UMB Scout Small Cap fund
UMBHX, +0.37%
which gained 24 percent in 2004. "It should be an up year, but much choppier -- possibly like the first half of this year was."

Science-and-technology sector funds eked out a 4 percent gain in 2004 on the back of a 16 percent fourth-quarter advance, while Lipper's health/biotechnology fund category rose 8.8 percent for the year and 7.5 percent in the fourth quarter.

"Health care next year could be one of the more interesting areas, and energy could be one of the least attractive," Bagby said.

Below-average exposure to technology stocks helped the Buffalo Small Cap Fund
BUFSX, -0.05%
outperform in 2004. Tech could benefit this year as businesses boost spending, said co-manager Kent Gasaway, and he's been eyeing software firms. Berwyn manager Grout is also interested in tech -- namely semiconductors.

"The line between growth and value has totally blurred," added Kunal Kapoor, director of fund analysis at investment research firm Morningstar. "A lot of value managers own former growth stocks. The growth managers do the reverse.

"It's reasonable to expect a rebound in growth," he added. "Given the number of value investors who own fallen growth, I wouldn't be surprised to see a resurgence benefit them as well."

Coming into 2004, U.S. stock funds needed to gain about 7 percent on average to erase the painful losses of the 2000-to-2002 bear market.

By that measure, funds delivered. Doing so for a third time next year would really be a charm.

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